Asset allocation isn't dead
One of the credos of the investment industry is that you need to own bonds as part of an investment portfolio. Recently, financial planner Ed Rempel has been challenging that rule, dismissing the need for bonds and instead going for an all-stock portfolio for people with long time horizons (like saving for retirement). His argument is that a portfolio that contains bonds doesn’t generate high enough investment returns to allow people to amass the savings they need.
His case is very convincing and for some people, I agree with the idea. But I think it’s foolhardy to dismiss the idea of owning bonds and do away with the idea of asset allocation.
Asset allocation is a really important financial planning concept. For those who are not super “into” investing, asset allocation is probably a term that goes in one ear and out the other because it sounds intimidating. Some people might throw it around inappropriately, as Tony Soprano does in The Sopranos he tells Carmella that he doesn’t have any cash sitting around because “I’ve got my money tied up in asset allocation.” I smile every time I think of this line. (Here’s another financial gem from Tony if you like the show as much as I do.)
Asset allocation is fancy word for how your money is invested across various asset classes. Asset class is a fancy word for type of investment. Let me speak in plain terms. Asset allocation is how you divide your money between stocks, bonds and cash. There are other asset classes that can be added to this list, but for most people, these are the three to be concerned about.
Top of mind
When you meet with an investment advisor, the first topic that will probably arise after the idle chit-chat is asset allocation. You’ll be asked to complete a questionnaire and from your answers, an asset allocation recommendation will be presented. The same thing happens when you buy mutual funds from a bank person and when you sign up with a robo-advisor. Is this simply a salesy gimmick? No, not at all. Asset allocation is really important. Here’s why.
1. Diversification. Simply put, owning more than one thing is important. In some years, stocks go down and bonds go up and vice-versa. In some years, stocks go up a lot and bonds go up a little and sometimes stocks go down a lot and bonds go down a little. (Rarely, stocks go down a lot and bonds go down a lot, like in 2022.) You get the idea. It's good to offset the losses in one asset with gains in another.
2. Owning different asset classes usually results in lower volatility, volatility being the ups and downs in value. This is important if you need to take the money out of your investment and spend it on something. You really want to avoid having to cash in your stocks right after a market decline – having some bonds and cash can mitigate this risk. As you can imagine, cash is the least volatile while stocks have the most volatility. One measure of volatility is standard deviation: how much the return of an investment deviates from its average return. It’s one thing to look at the average return of a stock but the average only tells part of the story. The standard deviation gives you a sense of whether you can expect pretty much the average return in most years or whether you can expect some big swings along the way. A higher standard deviation means an investment will be more volatile. You can have a look at some of the figures here.
3. Your asset allocation influences your investment returns. The higher your percentage allocation to stocks, the higher your expected return over the long run. Over the past 20 years, bonds have returned 3%, the Canadian stock market 8.5% and cash 1.5%. You can see the numbers here (it’s pretty interesting). If you have an investment portfolio that’s 5% cash, 20% bonds and 75% stocks, you can expect that you will earn about 7% over the long term. A 5%/40%/55% allocation returns more like 6%. (And Ed's argument is you need the full 8.5% of a 100% stock portfolio.) One way to determine your asset allocation is to work backwards: have a financial planner work out how much you need to earn in order to save enough for retirement and choose an asset allocation to match that return. If you are 45 and have saved nothing, you probably need a higher return. But if you’re already well along the way, you can earn something lower. Why take on more volatility than you need to?
Things to hone in on
An investment questionnaire will ask you a bunch of questions about your tolerance for risk, investment goals and so on. But what are the most important determinants of asset allocation? I think there are three.
1. Time horizon. Far and away this is the most important factor in deciding how to invest your money. Money you need soon needs to be safe – you cannot take the chance that it will decline in value just when you need it. If you have a long time horizon, there’s a much better chance that your investments will have gone up. For example, over any given one-year period, there is a 32% chance that you’ll lose money in the U.S. stock market, but over a 10-year period that falls to 12% and it goes way down to 0% over 20 year periods.
2. The sleep at night factor. This touchy-feely factor cannot be ignored when deciding how much of your money you should invest in stocks versus bonds and cash. After all, what’s the point of saving and investing for a happy future if it’s making you miserable now? If you are very nervous about the value of your money declining, see if you can rationalize yourself out of your fear and come to terms with it. (Looking at the long-term stock market chart can help.) If you can’t, you are going to have to settle the lower long-term returns that comes with a less volatile portfolio. Perhaps over time your ability to ignore market downturns will improve and you can adjust your asset allocation.
3. How you will be withdrawing the money – all at once or over a period of years? Imagine you’ve invested $100,000 in the stock market. Three years later you’ve bought a house and need the money for a down payment. Unfortunately, the market has just had two bad years and your $100,000 is now worth $80,000. That would be awful. However, if this money was set aside to pay for future family vacations (yeah, nice vacations!), you don’t need it all at once. You can take out $10,000 after three years (and lose just $2,000) and leave the rest, allowing it to recover in time for your next vacation.
Making the choice
If you work with a financial advisor or a financial planner, you’ll get help deciding on the right asset allocation for you. If you are a do-it-yourself investor, you’ll need to make that decision on your own. Try using an online questionnaire like this one to guide you.
Finally, don’t obsess about it – whether you choose to own 10% or 20% of your investments in bonds isn’t something to over-think. Either is probably fine. And this isn’t a “one way door” decision – you can always change your mind and choose a different allocation later on.
Photo by Lenstravelier on Unsplash